Q-Group Submission - Equity Lending, Investment Restrictions, and Mutual Fund Performance

Abstract

A securities lending program offers a unique opportunity for mutual funds to generate additional income. By lending the securities in their portfolio, funds can earn both interest and appreciation on the collateral of loaned securities. According to Data Explorers, mutual funds earned almost $1.5 billion in equity lending income in 2008. While the income that funds can generate through securities lending programs can be substantial, there is a potential disadvantage to securities lending. There is a substantial literature documenting that an increase in short selling of a stock precedes risk-adjusted underperformance of that stock. Because the demand for equity lending is primarily driven by short-sellers and increased short selling is such a strong signal about future underperformance, we might expect fund managers to sell the stock instead of keeping it in their portfolio and lending it. Thus, it is an empirical question whether the income generated from stock lending outweighs the potential adverse effects of holding securities that are being sold short. Using a sample of active and passive U.S. equity mutual funds over the 1996-2009 period, we will examine the economics of the lending decision itself, and explore why equity lending affects fund performance. The source of our data on securities lending practices is the SEC’s NSAR filings. We merge the NSAR sample of mutual funds with the CRSP mutual fund database and the resulting sample consists of 2,794 unique equity funds. The NSAR filings contain information on the investment restrictions and practices, including whether or not securities lending is allowed by the fund’s prospectus and whether or not they actually lend securities. The distinction between being allowed to lend and actually lending securities is an important one. While 82% of all funds in our sample are allowed to lend, only 32% are actually lending, on average, over the 1996-2009 period. Our preliminary results show that actively managed equity funds that lend securities underperform funds that do not lend securities but are allowed by their prospectus to do so. This finding is robust to the inclusion of many fund-level controls, including fund fixed effects, suggesting that fund heterogeneity cannot explain our findings. If the decision to lend shares is based on the demand by short-sellers for fund’s stock holdings, our findings suggest that short sellers are better informed than fund managers. Consistent with this interpretation of our findings, we find that index funds that lend shares do not underperform other index funds, in line with a lack of manager discretion on the part of those index funds both with and without equity lending programs. The idea that short-sellers are better informed investors is not surprising and is supported by a host of both theoretical and empirical papers. What is surprising about our performance results is that through their equity lending operation, fund families and managers receive a clear signal about the demand by short-sellers for the equities in their portfolio, but then fail to act on that signal by selling those stock holdings. One possible explanation for the underperformance is that funds might be limited in their ability to act upon the information signal. If the fund’s investment restrictions prevent the manager from holding cash or require the manager to hold certain types of securities (e.g. small cap value stocks), the manager may not be able to act upon the information he or she receives about the increased demand for borrowing the security. With restrictions in place that prevent a fund from selling a stock with borrowing demand, equity lending would at least generate some income to offset the potential underperformance. Using information from the NSAR forms (question 70N) we calculate an index of the investment and trading restrictions a fund faces to explore whether the fund underperformance related to security lending is concentrated among the funds with more investment restrictions. Our preliminary results show that the underperformance is concentrated among funds with more investment restrictions. The results suggest that mutual funds recognize the information signal but are limited in their ability to act upon it and therefore security lending is optimal in the suboptimal restrictive setting. In contrast, there is no evidence that the presence of an affiliated lending agent explains the negative link between fund performance and security lending by active funds.